Introduction to Fundamental Analysis

When I was starting out in the market I frequently fell, subconsciously, into the notion that a stock was just a number that moved up and down on my computer screen. I found myself checking the number often, thinking “go up you darned thing!” In focusing so much on price we lose sight of what we are really buying: a business. That business has products, customers, employees, assets, liabilities, etc.. It's these things that give a stock its value and ultimately drive its price over the long-term.

Understanding the things that give a stock its value, and the things that take value away, is vital to being a good investor. That's where fundamental analysis comes in.

Intrinsic Value

Price is what you pay. Value is what you get. - Warren Buffett

At the core of fundamental analysis is the concept of intrinsic value. Intrinsic value is one of the most important yet elusive concepts in investing. Wall Street analysts spend years studying, testing, and applying this concept yet it remains unattainable.

Intrinsic value should be a concept you are already familiar with. You know when you go shopping and check the price of an item, only to be shocked at how much it is? This occurs because there is a discrepancy between the figure on the price tag and how much value you perceive the item holds for you.

Every time you shop, your brain uses a very efficient system to quickly assess how much enjoyment or utility you will get out of owning the item. It then compares this to the magnitude of the negative emotion associated with losing the amount of money on the price tag (often the perception of an imagined loss is felt as keenly as a real one). If the magnitude of the positive emotion is much larger than the negative you might jump with excitement. It's a bargain! On the other hand, if the positive emotion is high but the negative emotion much higher you might groan in dismay.

Your brain is incredibly well-tuned to measuring the value of items like this. Unfortunately, measuring the value of a whole company is more complex. But while it is more complex, the concept is the same. Maybe one day you will be jump with excitement when you find a stock is trading at a discount or groan when you find it is significantly overvalued.

In finance, intrinsic value is a term used to describe the objective worth of an object. It is measured independently of all extraneous factors. It is extremely difficult to measure precisely because there are so many factors to consider.

Regular market forces cause price to deviate, and in some cases, significantly, from intrinsic value. As these forces swing between positive and negative, price fluctuates around intrinsic value. In this way, intrinsic value acts like a magnet on price, pulling it up when it falls below and down when it rises above.

Fundamental analysis allows us to approximately measure this deviation between price and intrinsic value. By comparing price to intrinsic value, we can determine whether a stock is undervalued or overvalued and therefore whether we should be buying or selling it.

Fundamental analysis can also reveal traits that indicate whether the company is of high quality and one that we want to own in the first place. But it is important to keep in mind that the relationship between price and intrinsic value can make or break an investment. The best companies in the world can make poor investments if purchased above intrinsic value. And poor companies can still make good investments if purchased below intrinsic value.

Financial Statements

Fundamental analysis involves studying a company's financial statements. By law, all public companies are required to periodically release financial reports to inform the market about how the company is doing.

There are three main reports included in a financial statement: the income statement, the balance sheet, and the cashflow statement. Financial statements are publicly available and can usually be found on the company’s website under “investor relations.” Here is Apple's investor relations website.

In this section we will learn how to read each of the three main financial reports, as well as metrics or indicators we can use to assess fair value, financial health, and efficiency.